Capital Budgeting under Certainty

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Capital Budgeting under Certainty
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Capital Budgeting

• The Planning for the Promotion Campaign and
  Development of available capital for the purpose
  of maximizing the long term profitability of the
  firm.
• The capital is relatively scarce and non-human
  resources of productive enterprise.
• As the firms decision to invest its current
  funds most effectively in long term activities in
  anticipation of an expected flow of future
  benefits over a series of years.
• Capital budgeting are (i) potentially large
  anticipated benefits (ii) a relatively high
  degree of risk and (iii) a relatively long time
  period between the initial outlay and the
  anticipated return.
• Paramount importance in financial decision
  making. Such decisions affect profitability of
  the firm and also have a bearing on the
  competitive position of the enterprise.

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Importance of Capital Budgeting Decision

1. It determines the future destiny of the company.
2. A capital expenditure decision has its effect
   over a long time span and inevitably affects the
   companys future cost structure.
3. Capital investment decisions, once made, are not
   easily reversible without much financial loss to
   the firm.
4. Capital investment involves costs and the
   majority of the firms have scarce capital
   resources.

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Steps of Capital Budgeting

• Calculation of Net Cash Outlay (NCO)
• Calculation of Annual Depreciation
• Calculation of Annual Cash Flow After Tax (CFAT)
• Calculation of Cash Flow in Final Year
• Evaluation of projects using capital budgeting
  technique
• Decision

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Step 1Calculation of Net Cash Outlay (NCO)

• - Purchase Price of New Assets x x x x
• - Transportation and Installation Cost x x x x
• Decrease or Increase in Working Capital x x
  x x
• Cash salvage value of Old Machine x x x x
• Tax saving on loss on sale of old machine x x
  x x
• Tax paid on profit on sale - x x x x
• Investment tax credit x x x x
• ?Net cash outlay Investment cost (NCO) x x x x

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Step 2 Calculation of Annual Depreciation

• Annual depreciation of new machine x x x x
• Less Annual depreciation of old machine x x
  x x
• Annual differential depreciation (New old) x x
  x x

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Step3Calculation of Annual Cash inflow after tax

• Annual increase in sales (New old) x x x x
• Less Annual increase in expenses (New old) x
  x x x
• Add Annual decrease in expenses (old new) x
  x x x
• Cash flow before tax and depreciation (EBDT) x x
  x x
• Less Annual differential depreciation x x x x
• Earning before tax (EBT) x x x x
• Less Tax _at_ ....... x x x
• Earning after tax (EAT) x x x x
• Add back Annual differential depreciation x x
  x x
• Annual cash flow after tax (CFAT) x x x x

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Step 4 Calculation of Final Year CFAT

• Differential Cash salvage value at end (New-Old)
  x x x x
• Book salvage value at end (New-Old) x x xx 
• Gain / Loss x x x x
• Tax paid on gai x xx x
• Tax saving on loss x x x
• Add Differential cash salvage value x x x
• Add Increase in working capital x x x
• Less Decrease in working capital x x x
• Add Annual differential CFAT x x x
• Final years CFAT x x x x

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Note

• Special assumptions for salvage value
• 1. When only the book salvage value is given, BSV
  CSV
• 2. When only the cash salvage value is give BSV
  0
• When only the salvage value is given, salvage
  value
• BSV CSV
• Special Assumption for depreciation
• When the income is given as earning, depreciation
  already deducted but not added.
• When the inflow is given as earning, depreciation
  is already deducted and added.

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Methods for Depreciation

• Straight line method
• Depreciation (Cost Salvage Value)/N
• Diminishing balance method
• Depreciation (Total cost or remaining value)
  ? ... p.a.
• Diminishing balance when rate of depreciation is
  not given,
• Depreciation Rate (2/n) ? 100
• Depreciation (Total cost or remaining value)
  ? ... p.a.
• Sum of year's digit method
• Depreciation (NCO x Remaining Life ) (n(n1)/2

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Evaluation Methods Of Capital Budgeting

• 1. Traditional or Non-discounted Methods
• (a) Payback Period (PBP)
• (b) Accounting Rate of Return (ARR)
• 2. Discounted Cash flow/Time Adjusted Methods
• (a) Net Present Value (NPV)
• (b) Profitability Index (PI)
• (c) Internal Rate of Return (IRR)

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Traditional Method or Non-discounted Cash Flow
Method

• Payback Period
• Even Cash flow
• PBP NCO/CFAT
• Uneven cash flow
• PBP Min. Year (NCO-Cum. CFAT)/Next
  years CFAT
• (b) Accounting Rate of Return
• Even case
• ARR ( EAT/Average Investment) ? 100
• Uneven case
• ARR ( AEAT/Average Investment) ? 100

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Discounted Cash Flow Method

• NET PRESENT VALUE
• Uneven case
• NPV Total Present Value Net Cash Outlay
• CFAT1xPVIF1 CFAT2xPVIF2
  CFAT3xPVIFN - NCO
• Even case Net Present Value
• NPV Total Present Value Net Cash Outlay
• CFAT x PVIFA - NCO

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Profitability Index

• Profitability index measures present value of
  return per rupee invested while the NPV shows the
  present value of return in lump sum.
• PI Total present value (TPV)/Net cash Outlay
  (NCO)
• The profitability index greater than one is
  accepted and less than one is rejected on the
  ranking of the projects, higher the profitability
  index is preferred.

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Internal Rate of Return (IRR

• It is the rate that discounts an investments
  future cash flows to the present so that the
  present value of those cash flow exactly equals
  the cost of the investment.
• This rate is also called as time adjusted rate of
  return, marginal rate of return, yield of
  investment and so on. The procedure of
  calculation of internal rate of return under even
  cash flow and uneven cash flow is different.
• EVEN CASH FLOW
• Step 1 To determine the factor by using the
  following formula
• Factor NCO/CFAT

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• Step 2 Locate the factor in the annuity table on
  the line representing the number of years
  corresponding to the estimated useful life of the
  project. Determine two rates, one more than and
  another less than factor.
• PVIFALr
• PVIFAHr
• Step 3 Interpolate the two factors from the
  following formula.
• IRR Lower Rate (PVIFALr-Pbf)/
  (PVIFALr-PVIFAHR) ? (Higher Rate Lower Rate)
• IRR must be greater than cost of capital. The
  higher rate of return is acceptable among the
  mutually exclusive proposals.

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• UNEVEN CASH FLOW
• -To determine the factor by using the following
  formula
• Factor NCO/Average CFAT
• - Locate the factor in the annuity table on the
  line representing the number of years
  corresponding to the estimated useful life of the
  project. Determine one rate close to payback
  factor, and compute NPV. If NPV is positive,
  increase discount rate, If negative decrease
  discount rate and Find one positive and one
  negative NPV.
• - To prepare the trial and error table and
  interpolate the two factors from the following
  formula
• IRR Lower Rate (TPV at LR NCO)/ (TPV at LR-
  TPV at HR) ?(Higher Rate Lower Rate)